Chapter 3
Consumer Impact
The Elderly Consumer
Well-meaning agents are often not as trained as the public needs them to be. The State of California is concerned about under-educated agents, but they are also concerned that new agents are taught inappropriate aggressive selling behavior.
As of January 1, 2004 agents must meet restrictions in the ways they may market annuities to older individuals. This was prompted by concerns that annuities and life insurance were sometimes sold to senior Americans using deceptive or arm-twisting methods. From a legal standpoint, a senior is a person age 65 or older. The author of the bills that resulted in this legislation (Senate Bills 620 and 618), Senator Jack Scott, states The majority of insurance agents are honest, but there is also a significant minority willing to take advantage of seniors. As is so often the case, all honest agents must jump additional hoops as the result of a few dishonest individuals.
Under these bills, before coming to a seniors home (this would be determined by the legal definition of senior) to sell an annuity or life product the agent must provide written notice in 14-point type that the point of the meeting is to promote or sell an insurance product. No longer may the agent merely show up at their door without notice. The written notice must also:
1. List the names of others, if any, who will accompany the agent. If applicable, the accompanying persons insurance license information must be provided.
2. Advise the senior that he may invite family members, attorneys, or financial advisors to the meeting and that the senior may end the meeting at any time.
Once the agent has arrived at the predetermined time at the seniors home, the agent must again state that the purpose of the meeting is to talk about insurance, or to gather information for a follow-up visit to sell insurance, if that is the case.
The law also addresses unnecessary replacement of policies. While it is advisable to replace some policies, many should not be replaced. This may especially be true of annuities due to the surrender charges and other restrictions that may exist in a new policy. Insurance tends to be a replacement business many policies have been replaced that should not have been. When that happens, the consumer is the loser. The law prohibits agents from using materially inaccurate presentations to persuade seniors to purchase replacement policies. Since replacing an existing annuity means a new surrender period begins, even when a newer policy might have some value, the new surrender period often wipes out any advantage of doing so.
Specifically, what is unnecessary replacement of an annuity under the law? It would be defined as a replacement that requires the insured to pay a surrender charge for that annuity being replaced and does not confer substantial financial benefit over the life of the new annuity product for the purchaser. An easier way to state an unnecessary replacement would be: an unnecessary replacement is one that a reasonable person (who has been provided all relative facts) would believe is not financially advantageous.
There are additional restrictions under SB 620 and 618. These restrictions include:
1. The sale of an annuity to a senior that is supposed to help the senior qualify for Medi-Cal assistance. Usually, the aim is to hide assets by placing them into an annuity. The restriction would apply to those sales for the purpose of qualifying for Medi-Cal when the seniors asserts are equal to or less than the Medi-Cal community spouse resource allowance (this figure changes periodically).
2. The restriction also applies to a senior, as legally defined, if the purchase of the annuity is to qualify for Medi-Cal and the senior would otherwise qualify without the annuity or after the purchase of the annuity, the senior or seniors spouse would not qualify so the annuity sale did not achieve that which was desired by the purchaser.
If the senior purchases the annuity product with the goal of qualifying for Medi-Cal and discovers that their objective was not met, he may then cancel the annuity and receive a full refund. If the senior purchased a fixed annuity, he must be refunded all premiums, fees, interest earned, and any other costs associated with the purchase. If the senior purchased a variable annuity, the senior must be refunded the account value.
The law makes it easier for seniors to receive a full refund if they cancel their purchase within 30 days. While the old law provided a 30-day free look, the new law states that the annuity must be invested in fixed-income accounts during this 30-day period, allowing the purchaser to receive a full refund even fro a variable annuity investment. The senior can waive this provision, but if they do so they run the risk of less than a full refund. For this provision, a senior is defined as a person age 60 or older rather than the other definition of age 65 or older.
An agent or broker is not allowed to share a commission or any other type of compensation (including a bonus or gift) with any active member of the California bar, unless the agent or broker is also an active member of the California bar. California enacted this legislation to prevent an attorney from referring or recommending insurance products to their clients in order to receive compensation from the selling agent or brokerage. Obviously a senior would trust his or her attorney so such an arrangement would benefit everyone except the consumer.
The law also targeted marketing, prohibiting the use of names that could mislead the consumer into incorrectly believing the seller is associated with a well-known group or organization. Why would an agent want their client to believe they were associated with a particular group? If the senior thought the agent was connected to a well-respected organization (such as AARP, for example) it could give a false sense of protection to the annuity or life product.
SB 618 increased the fines against insurers and their agents for misrepresentation and fraudulent activities. It also protected seniors from an agent who induces them to co-sign or make a loan, make an investment or a gift or provide any future benefit to the agent, with some exceptions. Additionally, an agent cannot persuade or recommend to a senior that he or she designate the agent as a beneficiary of the seniors will, life insurance policy, or annuity. Again, there are some exceptions, such as situations where the agent is also a relative of the insured.
Relaying Complete Information
Although many books and other articles may give a long list of annuity types, there are really only two: fixed or variable. All other types fall under one of these two categories. While senior Americans are among the most educated when it comes to financial vehicles it is still important that agents emphasize this point. Both types of annuities may be either immediate or deferred, meaning they may withdraw funds either immediately or at a later date. Unfortunately, many information sources talk about annuities as though they have a life insurance component to them. While there are aspects of the annuity that uses life insurance procedures, most annuities do not contain a death benefit. Mortality tables may be used, as they are in life insurance contracts, but that is not the same as a death benefit. Annuity funds are likely to be invested just as life insurance premiums are, but again this is not the same thing as a death benefit in the policy.
Some authorities call the promises made by annuity contracts regarding the premiums deposited the life insurance portion. The promises relate to the premiums deposited along with interest earnings in other words, the clients own money. In a variable annuity, the contract usually states that the beneficiaries will receive at least the premiums paid into the account. This may actually incorporate a type of life insurance since there is no promise that the variable annuity will not dip in value if the investments do poorly. Promising at least the premiums paid in might mean a higher value will be paid out, but usually the annuity does will enough (the account value is high enough, in other words) that such promises actually guarantees - would not apply. No investor should consider this to be life insurance since it is always better to actually purchase such a policy if life insurance is appropriate. Independent studies show that the life insurance aspect in variable annuities seldom applies since account values typically override any such guarantee. Many industry specialists feel it is best to purchase annuities that do not make such guarantees since it can drive up the cost of the vehicle.
Annuity contracts will usually contain a surrender period. During this period the insurer issuing the contract is discouraging policy cancellation by imposing a penalty, called a surrender penalty. The actual length will vary depending upon the contract, but an eight to ten year period is common. It is this surrender phase that is most often criticized by those who oppose annuities (such critics often oppose virtually all insurance products other than straight term life products and health insurance). The surrender penalty is there for a reason: to discourage withdrawal of funds. Annuities are intended for long-term use. Companies could make the guarantees they do if funds were easily withdrawn. It is surprising that this feature brings out so many critics since there are many types of investment products that use similar features, including certificates of deposit. Perhaps it is the fact that annuities tend to impose the longest surrender penalties which brings out such passionate critics. Even so, I find myself shaking my head. Surrender periods have always been as aspect of annuities; it is a defining feature of them. Those who concentrate on this feature miss the point of obtaining an annuity (lifetime income when annuitized). In fact, annuitization voids out the surrender penalties. It is also typically possible to withdraw a portion, usually ten percent, of the annuity proceeds annually without initiating any surrender penalties.
It is interesting to note that some consumer groups feel an annuity drawback is the tax burden that heirs might have from receiving the annuity funds. I would bet that most heirs are just happy to receive something and do not consider their tax liability to be an issue. One consumer group seemed to miss the point in this respect: first they said annuities did not earn as much as stocks did (a taxable asset), then said that the tax deferred status of annuities caused the tax rate of heirs to increase causing a financial hardship. As I have said, every group that is against one thing is FOR something else. No person should be fooled just because they call themselves a consumer group. Annuities certainly have their disadvantages along with advantages but to state the receipt of annuity proceeds is a disadvantage seems ridiculous. This particular online consumer group had three pages on annuities followed by two pages requesting consumer donations. As this demonstrates, nothing should be taken at face value. This organization purports to be a consumer advocacy group yet they put nearly as much space into collecting donations as they gave to their form of information. Included in their suggestions for ways to donate to their group were gifts through trusts or wills, outright donations including the use of a credit card, donating online, or donating any type of property or real estate. This is a California based nonprofit public benefit corporation. I wont print their name but you can find it by going online. It should be noted that they are online under several names, so look at the credits at the end of each article to determine if you are seeing the same group under different names.
No Financial Vehicle Fits Everyone
Every agent must realize that no financial vehicle is right for everyone. As people age this is especially true since older people have less time to recoup from mistakes. As we age we must be very careful how we use our money. That doesnt necessarily mean that annuities are wrong for older Americans but it does mean that they must understand them prior to purchase.
Agents have occasionally mistakenly thought that annuities will not affect an individuals Medi-Cal determination. What is Medi-Cal? It is the state program that pays for the persons health care, usually in a nursing home or some other type of long-term care service. Agents should never try to advise in this area since different circumstances can affect how an annuity will be viewed by California. Deferred annuities may affect their eligibility (the fact is, an annuity is an asset) but some annuities do not count as assets for eligibility purposes. Annuities are often called beneficiary assets because they are often deemed as beneficiary funds. However, state authorities are not stupid. They fully realize that annuities can be used by the policyholder, and often are. Even when the Department of Health Services does not count the annuity for eligibility for Medi-Cal they will seek to recover funds from the annuity following the individuals death. It should be noted that annuities are often the vehicle used for IRAs and 401(k) Plans. Retirement accounts do not usually count as assets for Medi-Cal eligibility calculations. Anyone thinking that they may need to qualify for Medi-Cal should seek out professional advise from an elder-care specialized attorney. An insurance agent is never in a position to offer advice of this type; only a foolish agent would attempt to do so.
Why does it seem like so many people (even some state officials) are against virtually all annuity sales? Either retirement funds or older Americans purchase most annuities. Those that are purchased by retirement funds are not in question because expert money managers handle these accounts and they know precisely what their goals are. Older Americans often are not sure what goals they should be pursuing and they have often been the victims of dishonest salespeople. There is great truth in the saying: It only takes one rotten apple to spoil the entire barrel. One rotten apple in the insurance industry makes all of us jump through many legal hoops.
Since consumer groups that push through our various laws often do not fully understand annuities it is easy to understand how they might think that all annuity sales are wrong. So the question is: should an older American purchase an annuity? The answer will depend upon many things, including the persons financial and personal situation and their needs and goals for the future. A person who plans to pay yearly nursing home premiums may want a vehicle that will produce enough income to do exactly that. Will an annuity meet that need? It would depend on how much they have to invest in an annuity, whether or not they have other funds that can be used for other financial requirements, and whether they can live adequately on their monthly income. Inflation must be considered in this equation, too. Spending power is likely to erode over time.
Many senior Americans will benefit from an annuity as part of their overall financial plan. It would probably be unwise to deposit all funds into an annuity; usually only a portion should be allocated to any one type of financial vehicle. As we have seen, California has specific laws regulating how an annuity may be marketed to a legally defined senior American. In most cases (there are always exceptions to everything), a senior American would be suitable for a deferred annuity if he or she did not need the principle in the immediate future. If income were desired the senior would probably be seeking an immediate annuity where the funds would be deposited and immediately annuitized for income. Individuals who do this usually want income for a specified period of time or even their lifetime. A deferred annuity would work for a senior American who had other means to pay for necessary items (such as nursing home premiums). Most annuities are considered long-term investments so do not sell an annuity to anyone of any age who will need the money sooner than later.
Whether or not an annuity is considered a valuable estate planning and income-producing tool will depend upon whom you listen to. I can never stress enough that everyone is for something. It might be something financially complex or something as simple as obtaining donations from those they scare with their financial reports. As a result it is important to consider all views, but take nothing at face value. Just as you will find groups that oppose annuities you will also find those that favor them. Both sides may bolster their view with slanted facts.
U.S. News & World Report (June 2005) stated that annuities have been receiving a bum rap. The article by Paul J. Lim said immediate fixed annuities were a sound alternative to the high-risk stock market for many retirees. This is especially true for those who must make their money last for many years. Academic research shows investors can afford to withdraw only 4 to 5 percent of their savings annually if they want to be certain the money will last 30 years or more, reported Lim. Thats if the funds are wisely invested, he added. He pointed out that even the President has broached the idea of retirees purchasing annuities with money earned in the private investment accounts he favors.
Lim feels the reason that annuities have received their undeserved bum rap relates to the confusion about them, partially sponsored by those who have other agendas and partially due to conflicting information. Many people associate the term annuity with variable deferred annuities, a combination life insurance and investment product that is often sold by agents who have not fully considered the needs of their clients. A variable annuity is a tax-deferred account used to accumulate assets for retirement, while a fixed annuity is a tool designed to produce stable income during retirement. This distinction is critically important, especially for the retiree who cannot easily earn back lost income.
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A variable annuity is a tax-deferred account used to accumulate assets for retirement, while a fixed annuity is a tool designed to produce stable income during retirement. |
As I said, many retirement programs purchase annuities, including Social Security. Why would retirement programs purchase annuities if they were bad investments as some would have us believe? In a way, we could consider the retirement annuity (a fixed annuity plan) to be our personal retirement account. Just as we should not drain our retirement account through our employer, we should not drain our long-term annuity (thus the surrender penalties to discourage this). The annuity is what will continue to pay us when we no longer have an income from employment. If the same money were sitting in a bank account how many people do you suppose would take it out to help their kid with his bills, buy a new car, or fund a current hobby? Americans do not have a good track record when it comes to retirement planning. The annuity is often the only savings vehicle that survives to retirement.
U.S. News & World Report writer Paul Lim states that annuities may be a better investment during some times than stocks, depending on market conditions. Baylor University investments Professor William Reichenstein studied various portfolios between 1972 and 2000. He found that a 65-year old retiree with a $1 million portfolio invested in a mix of 40 percent stocks and 60 percent bonds withdrawing $45,000 each year from his account would have run out of money in 1995 at age 88 (partly due to poor performance in stocks during the early years). Had he taken half of this portfolio and bought a fixed annuity instead, he would still have had $136,000 left at age 95. Obviously annuities arent such a bad choice after all.
Annuities have been criticized by some for their inability to increase income, once annuitized, as costs of living rise. In other words, the purchasing power of their dollar declines. Today some annuities include inflation protection, increasing their annual payments by 2 or 3 percent a year or by adjusting their payments based on consumer price indexes. However, before buying an annuity with an inflation rider the buyer should look closely at the product. Too often these riders come with a high price tag. At Vanguard, for example, a 70 year old who buys a $100,000 immediate annuity can expect to receive around $9,000 per year for the rest of his life. Add an inflation-indexed contract at Vanguard and that same man would begin payments at about $6,750 per year. While payments would increase, it is unlikely that he would ever receive more in income than he would have without the inflation rider.
Reichenstein says the good thing about annuities is their ability to function like bonds within a portfolio. The added advantage, according to him, is the lifetime versions that are available to retirees. Additionally, while bonds can lose value, there is no such risk with fixed annuities.
As we age, safety must be a consideration. Older Americans usually cannot make up losses (which is why the stock market is seldom considered a safe avenue for retirees). Insurance companies pool the money and life expectancies of thousands of annuity buyers. As a result they can usually offer more income than an investor could safely generate with the same amount of investment elsewhere. A 65-year old man might only be able to safely withdraw $5,000 annually from a $100,000 investment (the actual figure will vary with inflation) whereas he could withdraw $7,500 for the rest of his life from a fixed annuity.[1] Rande Spiegelman, of Schwab Center of Investment Research says this means that $750,000 in a fixed rate annuity is the equivalent to a million dollars in a different type of account.
Reading that statement, an agent might assume that everyone should buy a fixed annuity, but Spiegelman warns that this is not the case. Some people might already have enough guaranteed income from a traditional pension plan at work, for example. It is not wise to use all or even most of ones assets to purchase an annuity even a good one. You never know when an emergency might arise requiring immediate cash. Once annuitized, annuity funds are locked in, making them unavailable in a lump sum. Like a retirement account, the funds are only available over a period of time in installments. Just as we need to have three months of savings for safety during our working years, retirees need to have a cash reserve available for emergency expenses.
How does an agent determine how much should be tied up in an annuity? Figure the clients basic expenses, including rent or mortgage, food, utilities, and health care expenses. Do not overlook annual premiums for such things as nursing home insurance or fire insurance. Then add up expected income from Social Security and traditional pensions. If Social Security and other incomes do not fully cover costs an immediate annuity might be a good idea to fill the gap with necessary monthly income.
Never pressure your client into making a quick decision; doing so leads to regret. Be aware that annuity income may be tied to long-term interest rates. Payments are also tied to age, just like Social Security. Waiting to purchase an immediate fixed annuity or annuitizing an existing one, even for five years, may mean significantly higher income from the annuity if interest rates go up during that time period. Of course, not everyone can afford to wait to purchase an annuity. Many good annuities have acceptance limitations on age, for example. Some retirees may need to begin receiving income immediately so waiting to see if interest rates rise is not an option.
Drew Denning, a vice president for income management at Principal Financial suggests laddering income annuities the same way certificates of deposit are laddered. Everyone does not consider this a good idea, but for some it may allow higher income. Many professionals feel that consumers should consider having annuities with different companies to ensure the best growth over a period of thirty-five or forty years and to ensure financial strength. Annuities are a long-term contract. Only companies with the best financial ratings should be considered.
Annuities should be part of a diversified overall retirement plan. Seldom would they be the only financial vehicle utilized. Part of the retirement funds could go in a mix of bonds and stocks, which many consider a natural hedge against inflation. The level of money received from an annuity will depend upon three things: prevailing market interest rates, age, and gender (women tend to live longer than men so their annuity income is adjusted to reflect this).
An article in USA Today[2] stated that, according to a recently released government report, more and more retirees are choosing to cash out their retirement funds in a lump sum settlement rather than leave it in their retirement annuity. In most cases they feel they can do better by investing it themselves. If left in their retirement, they would receive a lifetime monthly annuity payment.
Many experts are concerned about this emerging trend. Workers are retiring earlier and living longer. An annuity, whether private or employer related, pays for as long as an individual lives. It is likely that many of those who cash out their retirement will outlive their money. When given a lump sum, retirees have a tendency to use too much of it in the early years of retirement. A lump sum retirement payout initially appears to be a lot of money so retirees feel they can spend freely and still have enough to live on. Says Alicia Munnell, director of the Center for Retirement Research at Boston College: In my view, lump sums are a very scary proposition. Researchers see the early retirement years spending on travel and big-ticket items, such as expensive travel trailers. Before the retiree realizes it, he can easily spend half of the retirement funds. By the time the individual realizes that the money is going out faster than it should there is too little left to provide a comfortable income for the remainder of his life.
It is difficult to compare a lump sum settlement with a monthly annuity payment, such as an employer sponsored retirement plan or private annuity. Consumers understand a lump sum differently than they do a monthly income. For example, if $100,000 equates into $1,000 per month for life the lump sum just looks better. Everyone figures they can do a better job themselves with their money. There is also the fear that they wont live long enough to receive the entire $100,000. And lets face it: we just like to spend more than we like to save. What people often fail to realize is that the monthly income is likely to produce more than the lump sum because it will continue to pay out past the $100,000 lump sum payment.
In order to make a comparison, it is necessary to estimate how much an individual could earn over time if the lump sum were invested. As the recent volatility of the stock market shows, this can be difficult to do. However, it might be a good idea to compare the pension annuity with a private annuity. Sometime (not always) it is possible to get a better return on a private annuity. The employer subsidizes many pension annuities so this should not be done without research. Workers who take an early retirement are most at risk for running out of money before they run out of life. If a worker retires at age 55, for example, his pension would be better under an annuity than it would be under a lump sum payout, but the employer is under no legal obligation to explain this. In fact, many employers would prefer that the retiring worker take the lump sum because it frees them from paying out more. Additionally, if the employer subsidizes the annuity payments, they are under no legal obligation to include this subsidy in the lump sum payment, so of course they do not add it. According to Karen Ferguson, director of the Pension Rights Center, those that take a lump sum at retirement rather than the retirement annuity end up forfeiting the early retirement subsidy that they thought they were receiving.
By law, pensions must calculate lump-sum payments based on the 30-year Treasury bond yield. The lower the rate used in the calculation, the larger the lump sum. The larger the lump sum the more attractive it looks to the retiring person, especially when compared to a monthly payout. Because Treasury no longer issues the 30-year bond, Congress is looking for alternatives to figuring lump sum payouts.
By law, traditional pensions must offer workers a stream of retirement income for as long as they and their spouses live. A 401(k) plan through an employer mostly offers a lump sum, which can be rolled over into an IRA and managed by the retiree. They could also purchase a private annuity.
Annuity Pros and Cons
It would be easy to think that an annuity is the perfect retirement vehicle for every person. Some experts say that, in theory, annuities are the perfect payout option since they have the ability to pay a lifetime income regardless of how long a person lives. Teresa Ghilarducci, associate professor of economics at the University of Notre Dame, said: If a husband cares about his wife, an annuity is a good way to protect her for life. When properly set up it will continue to give her income even after he has died. However, no investment is perfect and that includes annuities. Inflation is the drawback of any investment that fixes payment. Therefore, while an annuity is an excellent retirement vehicle, there must be a means of offsetting the rise of inflation, such as bonds, in addition to the annuity.
There is one particular situation where an annuitized annuity is not appropriate: when an individual is not expected to have a long life. Remember that it is not necessary to annuitize an annuity so it may be appropriate to hold funds in an annuity, but annuitizing it when life is expected to be short would be unwise.
An individual who is single or has a domestic partner (not legally married) might also benefit from a lump sum retirement payout rather than a retirement annuity. Since most retirement annuities, as well as lifetime payout private annuities, do not continue paying beneficiaries it is important to recognize the shortcomings of this.
Example:
Ron Retiree is single. He does have a live-in partner but there is no legal recognition to the partnership. If he takes a lump sum from his retirement plan, he can position the money so that any remainder will go to his partner. If he accepted the pension annuity, once he died his partner would receive no portion of any remaining funds. So, in this case, Ron would be better off taking the lump sum and investing it for himself. He must be aware, however, of the potential of spending the funds that were intended for retirement, which would leave him and his partner without adequate lifetime income.
Some retirees take the lump sum over the pension annuity because they fear for the safety of the funds. Even if the company goes broke, however, the pension benefits are insured by the Pension Benefit Guaranty Corporation. Unless the pension benefit exceeds the maximum benefit guaranteed (about $45,000 per year) it would be safe. It is important to note that the PBGC does not guarantee 401(k) plans. If the company does go under, it is unlikely that the retiree would immediately receive their retirement funds however. The retiree must be prepared for delays.
If the employee is certain he wants to take the lump sum retirement rather than use the pension annuity, it is important that he be a good money manager. Too many retirees have spent part of the money on items that will not pay the rent or put food on the table. The first thing to remember about taking a lump sum retirement is that it is not free money. It is for paying the day-to-day expenses of living so it must last the retirees lifetime. When a lump sum is taken the retiree must invest wisely and accurately estimate how long he will live. If he puts the money in to a private annuity, for example, and annuitizes for a ten-year period he is gambling that he will not live longer than ten years.
Many people report that lump sum settlements end up going to unexpected expenses, such as medical care. Of course, an annuity payout would not have prevented the illness but it may have made it easier to survive it financially without spending out all the funds since it may have made other payment avenues available.
Life Annuities in Individual Accounts
Virginia Reno, Vice President for Income Security at the National Academy of Social Insurance and Joni Lavery, Income Security Research Associate at the National Academy of Social Insurance, write that there is an inherent tension between the interests of heirs and the purchase of annuities because money used to buy a lifetime income annuity is no longer available to heirs.[3] When an annuity is purchased can greatly impact what amounts will be available to heirs. It is not surprising that children often have negative feelings about their parents buying annuities.
Obviously it is impossible to know how long any of us will live. However, we can look at our family for some ideas. If our parents, aunts, and uncles live into their eighties there is no reason to believe we will die sooner than that. It is also impossible to know what the cost of living will be in 30 to 50 years, but we can be sure it will be more than today. Returns will also impact how the investment performs. Because retirees cannot quantify their risks (longevity risk, investment risk, inflation risk) planning for retirement is a gamble. They gamble on how long they will live; they gamble on how much money they will need to live on, and they gamble on what their rate of return will be. Life expectancies show averages, but no one considers themselves average. About 11 percent of men and 7 percent of women who live to age 65 will die before their 70th birthday. On the other hand, 6 percent of men and 14 percent of women will live to see their 95th birthday. Many will live beyond that. This uncertainty makes it very difficult to calculate how much money we will need in retirement.
It is very difficult to know what will be required on a monthly basis by the time we are ninety. What was adequate income at 65 will not purchase the same amount 25 years later. Price increases of just 3 percent per year will make $100 today worth only $74 in ten years and just $45 in 25 years. Of course, this is the complaint against annuitized annuities: they do not grow with inflation. It is also why only 40 to 60 percent of retirement income should come from annuities. While annuities do provide lifetime income, that income is not likely to keep up with the rising cost of living. Of course, putting a portion of funds into stocks is not necessarily a solution either since it is possible to suffer losses in the stock market.
Social Security protects against many risks by paying benefits for life that are indexed for inflation and by providing automatic payments for spouses and widowed spouses. A spousal benefit is 50 percent of the retirees full benefits and is paid only to the extent it exceeds what the spouse would receive from her own work record. The surviving spouse can receive up to 100% of their deceased workers full benefits, but only to the extent that the benefit exceeds the widows own benefits as a retired worker. A life annuity can be used to protect against a shortage of income from Social Security benefits.
The National Academy of Social Insurance stated in a 2005 newsletter (by Virginia Reno and Joni Lavery) that life annuities work well in unison with Social Security since they can be structured to make up the shortage that would otherwise exist. As we know, Social Security is not intended to support a retiree, but rather supplement what he has done for himself. They stated that a purchase of a life annuity shifts the individuals longevity risk and investment risk to the insurance company when annuitized for the persons lifetime (this would not be accomplished if annuitized under some other option). Because insurance companies pool longevity risk over a large group of people, the extra funds from annuitants who die early are used to pay for those who live beyond their expectations.
Beneficiary Designated Vehicles
Versus Pension Designated Vehicles
Many products are annuities, but not all of them are designed for retirement income. When we talk about lifetime incomes it is very important to realize that this is referring to those annuities that are annuitized for lifetime income. The reason an individual would select the lifetime income is to supplement their Social Security and other pension designed incomes. Not everyone is comfortable with this annuitization option since it would pass no unused money on to beneficiaries. It is often those potential beneficiaries that are not happy with this annuitization option, in fact. However, it must be recognized that annuities that are used in the same manner as a pension are not beneficiary designated financial vehicles. They are pension vehicles so just as a company pensions would not pass on income to anyone other than the legal spouse neither will pension designated annuities.
Annuities may be annuitized under many options or never annuitized at all. It is important to distinguish between deferred and term annuities. Deferred annuities are tax-favored investment products that do not necessarily guarantee payments for life. Deferred annuities can be converted to life annuities, but statistically speaking, most are not. Those that are annuitized as term annuities promise specified payments for a given term (thus the name term), such as ten years. Term annuities obviously do not give income for ones lifetime unless that individual happens to die within the term agreed upon. If that happens, the annuitants beneficiary will receive any leftover funds. Only those annuities annuitized for the life option will guarantee lifetime income. Some annuities offer a combination annuitization option combining term and lifetime. For example, it may guarantee lifetime or twenty year term. In that case, the annuity would pay to the annuitant or his beneficiaries at least twenty years of income, but if the annuitant lives beyond twenty years, it will pay for his lifetime. If he lives beyond the twenty years his beneficiaries would receive nothing; only if he lived less than twenty years would they receive anything. How an annuity is annuitized will affect how much money is received each month. When term is combined with lifetime, the annuitant usually accepts a lower monthly benefit amount since the insurer carries increased risk.
Life Annuity Features
All life annuities are not equal. They may vary in how payments change over time, whether they change at all, whether they insure one life or more than one life, and the kinds of guarantees that are provided by the insurance company that issues them. Some insurers will add a guarantee specific to the insured dying soon after annuitizing for a life income. Each additional layer of annuity protections, such as inflation indexing or automatic survivor benefits, affects the monthly benefits that are paid. This may be referred to as affecting the size of the account balance. The National Academy of Social Insurance provides this example:
Terrence is a 65-year old retiree with $10,000 to invest for retirement. He could buy a flat, single-life annuity providing approximately $80 per month income. A single life annuity covers only one life, so it would not continue making payments to his wife if he should die. If the annuity were indexed to keep pace with a 3 percent inflation rate, Terrence would receive around $62 each month in income. If the annuity would continue to pay the same inflation-indexed monthly amount for as long as either he or his 65-year old wife lived, then the payment would start out at $50 per month (although it would rise according to the terms of the inflation benefit in the contract).
Some annuity contracts add guarantee features that promise a certain level of payout if the annuitant dies within a specified time after buying the annuity. It is always important to read the contract carefully since not all have the same short-life guarantee. Many guarantee at least a ten-year payout, but this can never be assumed. Some guarantee at least the principal deposited will be paid out to either the purchaser or his beneficiaries. It is important to remember that any additional guarantees made will affect how much the annuitant receives in benefits each month. The more risk taken on by the insurer, the less the monthly benefit will be. In the case of Terrence, adding the minimum benefit guarantee of at least the $10,000 deposited would reduce his monthly income by about $8 per month (the actual amount will vary from company to company, so it is important to shop around). Because it reduces monthly income, many annuity professionals believe it is unwise to buy such guarantees in the annuity contract. They feel that a pension goal should look at the amount of income available over the lifetime of the annuitant (and his spouse in many cases) and avoid adding on anything else, even an inflation benefit, that would reduce that income. Even so, many annuitants find themselves listening to their potential beneficiaries (usually children) and adding on such features, thus reducing their monthly income. Most pension annuities are purchased with a lump sum at retirement age, but more people are beginning to use annuities throughout their working years to accumulate for retirement.
What might a person receive under a life option annuity? Of course, that depends upon several factors, including the amount of money that was deposited in the annuity. If an individual buys a $100,000 annuity (so deposits $100,000) at age 65 and lives to be 95 he will have received approximately $240,000 over the 30 years he received benefits (based on 2005 interest rates). That is the equivalent of receiving a 7.2 percent annual compounded return on his original $100,000 deposit. On the other hand, if the same individual died at age 66, receiving benefits for only one year, he would get back only about $8,000 losing the balance of his purchase. Men receive higher payouts than women since women are expected to live longer. Therefore, if this example were on a woman, the amounts listed would be different. The longer one lives the more he or she will receive. This affects the rate of return that is shown (7.2% in this example). Insurance companies are very good score keepers; they know how long an individual is expected to live based on available social data. They establish the monthly benefit amount that will be received on this data so they know that those who live a long time like the man in our example will be less than those that die sooner. By pooling the money received from everyone, they are able to pay out the $242,000 from the $100,000 deposit. Companies also realize that beneficiaries will often persuade their policyholders to take other options so they are not required to pay a lifetime benefit.
Many policyholders do not realize the benefit consumer groups provide insurers. Since many of these groups oppose the gamble of lifetime income annuity selection, they will also play a role in persuading policyholders to take something other than a lifetime income selection.
Obviously current interest rates play a role in annuity payouts. Most annuities provide a minimum guarantee of 3 or 4 percent. The contract might pay a higher rate, but never a rate less than the minimum guarantee. The size of the benefit received will directly depend upon the current interest rate being paid. However, the rate of return is less an element of the annuitys worth than is longevity. The longer one lives the more he will receive on his original investment. There is always the possibility that the annuitant will receive less than his original investment if he dies before collecting the full amount, but since the objective is to receive retirement income that should not be a primary consideration.
Should Purchase Be Delayed?
Many annuity professionals suggest the purchase of an annuity or the annuitization of an existing annuity be delayed if financially possible. Some suggest delaying until age seventy if income is not critical before then. They feel the delay will mean the payout will then be driven less by interest rates and more by the companys estimate of how long the annuitant will live. Delaying will also give the annuitant an idea of his retirement health, which means he will have an idea of how long he might live. This allows him to look at all payout options and then select the one he thinks is best suited to him as an individual. Of course, there is no crystal ball; he may still live longer than he expected or die sooner than expected. By waiting, though, he is likely to have a better idea than he would have at age sixty. The extra ten years acquired by waiting until age seventy is likely a better indicator than he had at a younger age.
Waiting too long to purchase the annuity might be a mistake if the money that would have provided a lifetime income is spent on big-ticket items depleting necessary funds for retirement. He may even lend it out to his family, with the promise that they will repay it of course. Unfortunately, repayment doesnt always happen. Professional money managers report both to be a common occurrence. When an individual has $100,000 or more saved for retirement he may think that is much more than he will need, allowing him to rationalize using it for other purposes. If he had divided that money by twenty years, he would have realized that it only provides $5,000 per year (without counting interest earnings) for income. When viewed in that light, $100,000 is not much money. Statistically, men are more likely than women to believe they have enough money to live comfortably in retirement, with 50 percent of men compared to just 34 percent of women believing they have enough money.[4]
Baby Boomers Coming To Retirement Age
While annuities have always been considered a valuable retirement tool, it is likely that they will become more so as the baby boomers, those born from 1946 through 1964, hit retirement age, with the oldest of them turning 60 in 2006. This group has far fewer employer-sponsored pensions than did their parents, as pension plans disappear from corporate benefits. They do have such things as 401(k) and 403b Plans and IRAs, which their parents probably did not have. Baby boomers have heard negative reports on Social Security so they are less likely to place faith in the government pension program. Many financial planners are recommending that this age group roll their retirement money into programs that will guarantee lifetime income and annuities are often the program being considered. Half of the annuities sold are purchased with lump sum deposits, so we could assume that much of this money came from other work-related savings plans.
We know there are drawbacks in all types of investments, and annuities are no different. The largest drawback is the inability of the annuitized annuity to keep up with rising inflation rates. Fixed annuities are mostly invested in safe vehicles, such as bonds and mortgages, which means lower interest rates on paid. Low risk always equates into low returns. For every dollar invested in a fixed rate annuity, after operating expenses, marketing expenses, and insurer profits about 85 cents is returned to the average investor.[5] Of course, the key word here is average. Some will receive less and some who live a long time will receive more.
Even though there are certainly disadvantages to annuities, most professional financial advisors feel the advantages outweigh the disadvantages when used for retirement as a lifetime income. The popularity of annuities, even among financial advisors comes and goes depending on the current financial climate. When other money vehicles are enjoying high interest rates annuities lose favor. When stock markets are volatile and appear riskier, annuities become popular. During the Great Depression, annuity sales exceeded life insurance sales.
Baby boomers report having the same concerns as their peers during the Great Depression so of course, annuities are often favored for their safety. Investors can maximize their return on annuities by performing some research. Agents should certainly do the same research for their clients. Focus on insurance company overhead expenses. The lower the expenses, the more money will be passed on their policyholders. Do not overlook sales charges and annual expenses. A combination of low sales charges and low annual expenses will provide the best purchasing power for investors. Expenses can range from half a percentage point to more than one percent.
Many investors seem to be favoring variable annuities in an attempt to keep pace with inflation, but it is important to realize that what goes up can also go down. In the 1990s variable annuities were realizing high returns but many of them had expenses of two percent or more. Now, fifteen years later, many of those variable annuities have lost what they previously gained but still contain the high expense charges.
Recent competition has reduced commissions for variable annuity sales and many of them are better products as a result. Even so, no one should go into a variable annuity unless they fully understand the product. Certainly agents should not be selling anything they do not fully understand. Annuities are much more complex than agents let on to their clients. On the surface annuities seem pretty simple; seldom do clients understand the fees that are built into them. It is the rare agent that explains those fees to their buying clients. I recommend the following:
1. Represent only top rated, financially strong companies. Annuities may need to pay benefits for three or four decades. It is never worth considering anything less than a top rated company.
2. If a lifetime guaranteed income is the goal, it is often best to use a fixed life annuity.
3. If the buyer is comfortable with stock market returns and can hand the variability of them, a variable annuity might make sense, but ONLY if the buyer fully understands the possible ups and downs of such a product.
4. Specifically look at the companys expenses. Since there are fixed rate annuities that keep their costs to investors at half a percent, seek those out. For variable annuities, expect to pay around 1 percent. There is no need to pay more than necessary for either type. When presenting these low cost companies, explain why this is important to your clients (to get the best return). If your client understands that you gave them the best product, the next guy in their door will have a harder time replacing your product with his.
5. Most annuities do not care how healthy your client is. They are more concerned with what affects their payout, namely age and gender. Individuals who are lucky enough to have good genes and who pay attention to their health can expect to do the best with a lifetime annuity. Those with poor health may not want to utilize this annuitizing option.
6. Any product that pays more than a six or seven percent commission probably has higher fees than one that pays less. While agents certainly have the right to earn a living, selling products with the highest commissions are seldom in the best interest of your clients. Agents who do not consider the best interest of their clients are not likely to flourish long term. Dont hesitate to disclose what rate of commission you earn. Encourage your clients to ask that of other agents who call on them. If the agent refuses to disclose this information, let your clients know there is likely a reason. Does this sound rash? Its not. The public surely knows that we must earn a living the same as a plumber, office worker, or nurse. Once they understand that we work hard, service many products without compensation, and still must pay our bills there will be less problems with those who make such silly statements as: Many people are not aware that the agent receives a commission from selling annuities. If we were paid an hourly wage by the insurer the company would still build that into the contract fees. Either way, most of us count on our commission to live; few of us have a rich daddy.
Any commissioned job is difficult. In order to survive, the agent must be able to perform their job well. Those who cannot communicate well, who do not understand their products, or who are not personally disciplined will move on to an hourly wage where the paycheck appears whether they are good at their job or not. Annuities can be a great way to achieve many of your clients goals, but only if the agent first does their job of due diligence. Once the agent has determined the best companies to represent, and the best products to recommend he is then in a position to help the client do their job: determine if they are in the half who will outlive their life expectancy or in the half that will die prematurely.
End of Chapter Three